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Government Is a Lousy Venture Capitalist

Friday, February 24, 2012

While government has a legitimate and valuable role in basic science, technology, engineering, and mathematics research, it is a lousy venture capitalist and is largely incapable of picking winning technologies in the market.

In their article, “Lessons from the Shale Revolution,” Ted Nordhaus and Michael Shellenberger suggest that the success of hydraulic fracturing validates the idea that government “investment” is a reasonable and effective way to advance technology and to outperform market actors in finding and bringing cool new things to fruition. President Obama made the same argument in his 2012 State of the Union address, giving almost complete credit for hydraulic fracturing to Uncle Sam:

The development of natural gas will create jobs and power trucks and factories that are cleaner and cheaper, proving that we don’t have to choose between our environment and our economy.  And by the way, it was public research dollars, over the course of 30 years, that helped develop the technologies to extract all this natural gas out of shale rock–-reminding us that government support is critical in helping businesses get new energy ideas off the ground.

Nordhaus and Shellenberger come down unequivocally on the president’s side of this argument:

In fact, virtually all subsequent commercial fracturing technologies have been built upon the basic understanding of hydraulic fracturing first demonstrated by the Department of Energy in the 1970s.

They also suggest that the same approach will foster the development of renewable energies such as wind and solar power:

Indeed, once we acknowledge the shale gas case as a government success, not a failure, it offers a powerful basis for reforming present clean energy investments and subsidies.

This argument is a direct contravention of the conventional wisdom that while government has a legitimate and valuable role in basic science, technology, engineering, and mathematics (STEM) research, it is a lousy venture capitalist and is largely incapable of picking winning technologies in the market.

Critics of the government’s claim of credit argue, in essence, that the government pulled a Ferris Bueller: They saw a parade in progress, hopped up on a float, and started singing loudly and gesturing broadly. Now, they claim credit for the entire parade. This is a fairly common practice. Quite recently, President Obama claimed credit for increased oil and gas production in the United States, despite it being blatantly obvious that the increases came from state and private, not federal, lands.

But for argument’s sake, let’s stipulate to the premise that hydraulic fracturing technology represents a great government success. What can we learn from this shining example?

Not much, for two reasons:

1) One winning game does not a champion make. Nordhaus and Shellenberger take the fracking example in isolation, and ignore persuasive literature showing that “industrial policy” (the formal term for government picking winners and losers) has a history of abject failure. Some, such as Terence Kealey at the University of Buckingham, point out that Japan’s efforts at industrial policy (through an agency called MITI) were simply a disaster:

MITI, far from being a uniquely brilliant leader of government/industrial partnership, has been wrong so often that the Japanese themselves will concede that much of their growth derives from industry’s rejection of MITI guidance. MITI, incredibly, opposed the development of the very areas where Japan has been successful: cars, electronics, and cameras. MITI has, moreover, poured vast funds into desperately wasteful projects. Thanks to MITI, Japan has a huge over-capacity in steel—no less than three times the national requirement. This, probably the most expensive mistake Japan ever made in peacetime, was a mistake of genius because Japan has no natural resources: it has to import everything; the iron ore, the coal, the gas, the limestone, and the oil to make its unwanted steel. (p.111)

Kealey points to a comprehensive study of MITI interventions between 1955 and 1990, observing that:

Richard Beason of Alberta University and David Weinterin of Harvard showed that, across the 13 major sectors of the economy, surveying hundreds of different companies, Japan’s bureaucrats almost invariably picked and supported the losers. (p.111)

As Obama’s own economic adviser Larry Summers pointed out, the government is a bad venture capitalist. It has no greater ability to pick winners than does any private individual, but it can be far more reckless in its “investments” because there is no penalty for wasting money, and because it can use state force to favor cronies and rig outcomes. Sure, the government invested in hydraulic fracturing, but were their investments key to its success, or are they simply claiming credit for an accidental situation where something went right? Based on the evidence, the latter is more likely than the former.

2) Displacement is not addition. Studies show that government “investment” in applied research and development does not add new money to the pot, it displaces private capital, and does so disproportionally. When government steps in, it displaces more money than it throws in the pot.

Again, Kealey sums it up well using a study by the OECD:

Furthermore, regressions including separate variables for business-performed R&D and that performed by other institutions (mainly public research institutes) suggest that it is the former that drives the positive association between total R&D intensity and output growth... The negative results for public R&D are surprising and deserve some qualification. Taken at face value, they suggest publicly performed R&D crowds out resources that could be alternatively used by the private sector, including private R&D. There is some evidence of this effect in studies that have looked in detail at the role of different forms of R&D and the interaction between them. (p.19)

Kealey’s own research agrees:

Moreover, the OECD does not stand alone: at least two other researchers, Walter Park of the Department of Economics at the American University at Washington, D.C., and myself, have found—by similar surveys of OECD data—similarly damaging effects of the government funding of research and development.

Government, like a really bad surgeon, sings the praises of patients it heals and buries those it mangles, quietly when it can, and loudly blaming others when it can’t. As Frédéric Bastiat explained some 150 years ago, economic actions have both seen and unseen consequences. Fans of industrial policy are keen to point out the seen, and never countenance the unseen waste and opportunity costs.

I gladly walk with Nordhaus and Schellenberger when they argue that supporting basic research in STEM fields is a valid, important, and often beneficial governmental activity. However, we fall out of step when they start endorsing industrial policy and having bureaucrats pick winners and losers in the market.

Kenneth P. Green is a resident scholar at the American Enterprise Institute.

FURTHER READING: Green also writes “Not Free to Choose: The Reality behind Clean Energy Standards,” “With Climate Change, Life Imitates Art,” and “Obama’s Energy Blueprint: Same Silliness, Different Day.” Jon Entine contributes “Future Energy: Natural Gas Fracking—Who Blew Up the 'Bridge to the Future'?” and “Killing Drilling With Farcical 'Science'.” Mark J. Perry says “Michigan Has Much to Gain From Safe Fracking Technology.”

Image by Rob Green / Bergman Group

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